Implied volatility is a metric that represents the market’s forecast of a likely movement in a security’s price and is used to price options contracts.
Understanding implied volatility
Implied volatility derives from the current market price of an option and indicates the expected future fluctuations of the underlying asset. It is a forward-looking measure. When market participants anticipate a large price movement, implied volatility increases. When expectations point to stable prices, implied volatility decreases. This metric does not predict the direction of the price movement, only the expected magnitude of the swing.
This differs from historical volatility, which measures past price changes over a specific period. Implied volatility estimates future price changes over the life of the option contract. In standard options pricing models, implied volatility is the only variable that is not directly observable in the market. Market participants input the current option premium, the strike price, the underlying asset price, the time to expiration, and the risk-free interest rate into the model to calculate the implied volatility. Because it is derived from the option premium, implied volatility is a direct reflection of market supply and demand for the contract.
For Elephants trading derivatives, monitoring implied volatility is a standard practice. High implied volatility results in higher option premiums because the probability of the option moving past the strike price is perceived to be greater. Low implied volatility results in cheaper options. Traders compare current implied volatility to historical volatility to assess whether options are relatively expensive or cheap before executing a trade.
Example
Imagine an international agricultural firm named Elephant Peanuts Ltd, which has shares traded on a public exchange. The company is scheduled to release its annual earnings report next week. Currently, the stock trades at 50 per share. Options traders expect the stock price to move significantly after the earnings announcement, though they do not know if the price will go up or down. This expectation drives up demand for both call and put options on Elephant Peanuts Ltd.
Due to the increased demand, the premiums for these options rise. When these higher option prices are entered into a pricing model, the resulting implied volatility is 60 percent. A month prior, when there were no scheduled announcements and the stock price was stable, the implied volatility for the same options was 20 percent. The increase from 20 percent to 60 percent shows that the market anticipates a much larger price swing for Elephant Peanuts Ltd shares in the near term.